SECTION 457 PLANS

These plans are primarily used by government employers. Government employers may have qualified plans for employees, except that they are not eligible to adopt 401(k) plans. And, only a very limited category of government employers (public schools) can adopt 403(b) plans. Thus, the opportunity to offer employees a plan of the salary savings type is very limited. Section 457 provides the only alternative in designing a salary savings arrangement for most government employers. Plans designed under this Code provision are not qualified plans; moreover the rules are in many cases very different from those. The rules were enacted by Congress primarily to forestall perceived abuses in retirement plans of government employers rather than to benefit government employees, so they are somewhat lacking in flexibility or generosity.

Eligible Employers

Section 457 applies to government employers and to employers that are exempt from federal income tax. However, these plans are not much used by private tax-exempt organizations because better alternatives such as 401(k) plans are available.

Limit on Amount

The amount deferred annually by an employee under these plans cannot exceed the lesser of $7,500 or one-third of the employee's taxable compensation, reduced by any salary reductions under a Section 403(b) plan or SIMPLE. The $7,500 limit is indexed for inflation (2000: $8,000). This ceiling can be increased in each of the last three years before normal retirement age, to the lesser of $15,000 or the regular ceiling plus the total amount of potential deferral that was not used in prior years. If an individual has more than one employer, the total deferred for all employers must not exceed these limits.

Other Rules

• Elections to defer compensation under Section 457 are made monthly, under an agreement entered into before the beginning of the month.

• For government employers, employee salary deferrals must be placed in a trust fund or custodial account. However, for private tax-exempt employers, the plan cannot be funded—all deferred compensation and income therefrom remains the property of the employer.

• Plan distributions cannot be made before separation from service or "unforeseeable emergency."

• Plan distributions must meet the minimum distribution rules of Section 401(a)(9) regarding beginning date (April 1 after age 70½ or retirement).

• A special incidental death benefit provision applies—the participant must expect to receive at least two-thirds of the total payout where there is a survivor annuity.

• Plan distributions are taxable in full when received. They are not eligible for five- or ten-year averaging and cannot be rolled over into an IRA.

• There are no specific coverage requirements—the plan can be offered to all employees, or any group of employees, even a single employee. However, for a tax-exempt organization (but not for a government organization) the participation, fiduciary, and other ERISA rules may apply.

If the state or local government employer or tax-exempt employer has a nonqualified deferred-compensation plan that does not comply with Section 457—for example, one that exceeds the limits—then it is treated for tax purposes as a funded plan, whether or not it is actually funded. This means that the deferred amount is includable in the participant's income when there is no substantial risk of forfeiture. This does, however, provide some opportunity for governments and tax-exempts to design plans for top executives above the $7,500 limit by including forfeiture provisions.

SECTION 401(K) PLANS (CASH OR DEFERRED PLANS)

A qualified cash or deferred profit-sharing plan, usually referred to as a 401(k) plan because the special rules for these plans are found in Code Section 401(k), is a qualified profit-sharing or stock bonus plan that incorporates an option for participants to put money into the plan or receive it as taxable cash compensation. In other words, a 401(k) plan differs from a regular profit-sharing plan in that employees can participate in deciding how much of their compensation is deferred. Amounts contributed to the plan are not federal income taxable to participants until they are withdrawn; this is a significant advantage over contributions to a savings plan, which are taxable to the employee before contribution to the plan. However, 401(k) amounts for which the employee can elect to receive either cash or a plan contribution—elective deferrals—are subject to an annual limit of $9,500, indexed for inflation (2000 figure is $10,500).

A 401(k) plan can be an independent plan or the 401(k) feature can be included with a regular profit-sharing, savings, or stock bonus plan of the employer. The plan can be designed in a number of ways to combine both employer and employee contributions, or the entire plan can be funded through salary reductions by employees.

Eligible Employers

Section 401(k) plans can be adopted only by private employers, including tax-exempt organizations. They are not available to government employers. Government employers may be eligible to adopt Section 403(b) or Section 457 plans to provide results somewhat similar to 401(k) plans.

Advantages and Disadvantages

Section 401(k) plans are currently very attractive to employees. First, they have the basic attraction of all qualified plans—they provide a tax-deferred savings medium. But 401(k) plans have an additional advantage by giving employees an opportunity to choose the amount of deferral according to their individual need for savings. From the employee's viewpoint, a 401(k) plan appears much like an individual IRA, but with additional advantages: The 401(k) plan has higher contribution limits than an IRA, in certain cases it provides special averaging on qualifying lump-sum withdrawals, and the withdrawal provisions during employment are slightly less restrictive.

From the employer's viewpoint, 401(k) plans are favorable because the entire plan can be funded through salary reductions by employees. Thus, the plan provides no direct additional compensation costs to the employer. Because of the popularity of the plan with employees, partly due to good publicity for these plans in the media, the employer can obtain employee goodwill with this type of plan at a relatively low cost. There are also some actual dollar savings in using the 401(k) type of design, because salary reductions by employees may reduce employer expense for workers' compensation and unemployment compensation insurance by reducing the payroll subject to those taxes.

The 401(k) type of design has some disadvantages, but in reviewing these it is important always to ask disadvantages to whom and disadvantages compared with what? First of all, the $9,500 (indexed) annual limit on elective deferrals is lower than that for other types of qualified plan contributions. However, as a practical matter, this limit primarily affects highly compensated employees. Another disadvantage is that a 401(k) plan is a qualified plan and as such is much more complicated than simply leaving savings up to individual employees, either through individual IRAs or otherwise. Also, the 401(k) plan is a qualified profit-sharing plan, not a pension plan, so the employer's deduction is limited to 15 percent of the covered payroll. That is, the total of the employer contribution and nontaxable employee salary reductions cannot exceed 15 percent of covered payroll. Generally speaking, integration of a 401(k) formula with Social Security is not possible, but the 401(k) nondiscrimination rules nevertheless permit significant discrimination in favor of higher-paid employees. Section 401(k) plans are more difficult to administer than regular qualified plans because of the additional rules (discussed later) that must be satisfied. Deferral amounts must be 100 percent vested; thus, there is no opportunity for the employer to save on plan costs by making use of employee forfeitures on Section 401(k) deferral amounts. Finally, distributions to employees prior to termination of employment are more restrictive than for a regular qualified plan. However, these restrictions are more liberal than those for an IRA.

Employer Matching Contributions

Under this approach, participating employees can elect salary reductions, with the employer making a matching contribution to the plan. The employer share can be dollar-for-dollar, or some specified fraction of the employee's contribution. Matching can be limited to a specified percentage of each employee's compensation. For example, a plan might provide that an employee can elect salary reductions up to 6 percent of compensation, with the employer contributing an additional 1 percent of compensation for each 2 percent of employee salary reduction.

A significant advantage to this approach is that employer matching encourages plan participation by lower-paid employees. This helps to meet the qualification tests for 401(k) plans—the actual deferral percentage tests discussed later.

Employer Profit-Sharing Contributions

The plan also may provide for additional employer contributions not related to salary reductions by employees. These contributions can be completely discretionary or subject to a formula, as in the case of a regular profit-sharing plan. These contributions can be allocated in any manner permitted in a profit-sharing plan, including a simple uniform percentage of the participant's compensation as well as integration with Social Security or an age-weighted or cross-tested approach.

Employee After-Tax Contributions

The plan may permit employees to make additional after-tax contributions to the plan—that is, contributions not subject to the elective deferral rules and subject to income tax. These contributions are treated like employee contributions to a thrift or savings plan, discussed earlier.

Coverage Requirements

Because a 401(k) plan is a qualified profit-sharing plan, it must meet all the eligibility and coverage requirements discussed earlier for qualified plans in general. However, substantial additional participation by lower-paid employees may indirectly be required to meet the actual deferral percentage requirements applicable under Section 401(k) as discussed below.

Vesting of Employee Accounts

Vesting requirements in a 401(k) plan may depend on the source or identity of the plan contributions.

• Nontaxable employee salary reductions or elective deferrals made under a Section 401(k) cash or deferral option must be immediately 100 percent vested.

• Any after-tax employee contributions must be 100 percent immediately vested, as in qualified savings or thrift plans, discussed earlier.

• Employer contributions to the plan must meet the usual vesting rules for qualified plans. That is, the plan must have a vesting schedule for employer contributions that at least meets one of the ERISA minimum vesting standards (five-year vesting or three- to seven-year vesting).

$9,500 Limit on Elective Deferrals

Code Section 402(g) imposes a $9,500 annual limit on elective deferrals for each plan participant. The limit is imposed on the total of elective deferrals under all 401(k) plans, Section 403(b) tax-deferred annuity plans, and SIMPLEs covering the participant. The plan may not permit elective deferral contributions in excess of this limit. The $9,500 limit is adjusted for cost-of-living changes (2000: $10,500).

Designing a Plan To Meet the ADP Tests

Obviously, it is critical to design the 401(k) plan so that the ADP tests are met; otherwise the plan will fail to qualify and all tax benefits will be lost. Fortunately, it is not as difficult as plan designers once believed and disqualifications are rare. Some of the methods used to ensure compliance are as follows:

• Mandatory deferral. For example, an employer contributes 5 percent of compensation for all employees that must be deferred and allows an additional 2 percent under a cash or deferral option. This plan will always meet the second ADP test.

• Limiting deferral by the higher paid. This approach involves administrative problems. The highly compensated group must be identified and deferral must be monitored, with a mechanism to stop deferrals at an appropriate point during the year if necessary. Alternatively, excess deferrals for highly compensated employees can be computed at the end of the year and corrective distributions, including interest earnings, made to affected employees. Such corrective distributions are income-taxable to the recipients and must be made within 2½ months after the end of the plan year to avoid an additional penalty tax. Instead of cash distributions if the plan permits after-tax contributions, these excess amounts can be retained in the plan and recharacterized as after-tax contributions within 2½ months after the plan year. Related matching contributions can be forfeited and generally cannot be distributed.

• Counting on the popularity of the 401(k) approach. In actual practice, many companies find that participation by lower-paid employees is substantial. It is not unusual for 75 percent of all employees of an organization to participate in the plan. This may eliminate the problem without any special mechanisms coming into effect.

Because of the ADP tests, not every employer is suitable for a 401(k) plan. Because substantial participation by lower-paid employees is necessary, pay levels must be reasonably high in the organization, at least high enough so that some amount of retirement saving is possible by most of the employees.

Distribution Restrictions

Account balances attributable to amounts subject to the cash or deferral election—the 401(k) amounts—are subject to special distribution restrictions. These amounts may not be distributed earlier than on retirement, death, disability, separation from service, hardship, age 59½, or termination of the plan. Also, as with any qualified plan distribution, the 10 percent early withdrawal penalty applies. Amounts attributable to matching and profit-sharing contributions can generally be withdrawn according to the rules for profit-sharing plans discussed earlier.

The income taxation of distributions from 401(k) plans, including both 401(k) and non-401(k) amounts in the plan, follows the usual rules for qualified plan distributions. The qualified plan rules relating to loans and plan distributions.

Social Security and Employment Taxes

Section 401(k) plans are an exception to the general rule that contributions by an employer to a qualified plan are free of federal employment taxes (Social Security [FICA] and unemployment tax (FUTA)). The popularity of 401(k) plans when first introduced caused such a noticeable reduction in federal employment tax revenues that Congress made special rules for 401(k) plans. Under current law, 401(k) amounts subject to an employee election to defer instead of receiving cash (elective deferrals) are subject to FICA and FUTA, whether these are contributed through salary reduction or employer bonuses. FICA and FUTA do not apply to non-401(k) amounts—matching or profit-sharing contributions made by the employer to the plan that are not subject to elective deferrals.

In general, state unemployment compensation and workers' compensation payments are not required for either employer contributions or salary reductions in a 401(k) plan.

PLANS FOR SPECIAL TYPES OF ORGANIZATIONS

Plans Covering Partners and Proprietors

Under federal tax law, partners and proprietors (sole owners) are not considered employees of their unincorporated business, even if they perform substantial services for the business. By comparison, shareholders of a corporate business who are employed by the business are considered employees for retirement planning and other employee benefit purposes. For many years, there were restrictions on the benefits available from a qualified plan to partners or proprietors. Special plans called Keogh or HR#10 plans were used if partners or proprietors were covered. Since 1983, most of these restrictions no longer apply, and qualified plans can cover partners and proprietors on virtually the same terms as regular employees of the business.

S Corporations

An S corporation is a corporation that has made an election to be treated substantially like a partnership for federal income tax purposes. Certain shareholder employees of S corporations were once subject to qualified plan restrictions similar to those for partners and proprietors; however, after 1983, most of these restrictions do not apply. Thus, as with partners and proprietors, S corporation shareholder-employees are now treated basically like regular employees for qualified plan purposes. However, an S corporation employee who owns more than 2 percent of the corporation's stock is treated as a partner for other employee benefit purposes, such as group life and health plans.

Multiple Employer, Collectively Bargained, and Multiemployer Plans

In this text, if not stated otherwise, it is assumed that any qualified plans referred to are maintained by a single employer or by a group of related employers. It is possible, however, for more than one employer or related group to participate in a single qualified plan. If such a plan is established under a collective bargaining agreement (as is usually the case), it is referred to as a collectively bargained plan. With a collectively bargained plan, the plan is usually designed and maintained by a labor union, and employers who recognize the union as a bargaining agent for their employees agree to contribute to the plan on a basis specified in the collective bargaining agreement. If the plan is not the result of a collective bargaining agreement, it is referred to as a multiple employer plan. Such plans might, for example, be maintained by trade associations of employers in a certain line of business. There are special rules for applying the participation and other requirements to these plans.

There are also provisions for a special type of collectively bargained plan known as a multiemployer plan (Code Section 414(f)). A multiemployer plan is a plan to which more than one employer is required to contribute and that is maintained under a collective bargaining agreement covering more than one employer; the Department of Labor can also impose other requirements by regulation. Presumably, most large collectively bargained plans will qualify as multiemployer plans. Because of the nature of the multiemployer plan, the funding requirements are somewhat more favorable than for other plans. However, the employer may incur a special liability on withdrawing from the plan.

ISSUES IN PLAN DESIGN | Cafeteria Plans

Before committing itself to the establishment of a cafeteria program, an employer must be sure a valid reason exists for converting the company's traditional benefit program to a cafeteria approach. For example, if there is strong employee dissatisfaction with the current benefit program, the solution may lie in clearly identifying the sources of dissatisfaction and making appropriate adjustments in the existing benefit program, rather than in shifting to a cafeteria plan. However, if employee dissatisfaction arises from widely differing benefit needs, conversion to a cafeteria plan may be quite appropriate. Beyond having a clearly defined purpose for converting from a traditional benefit program to a cafeteria program and being willing to bear the additional administrative costs associated with a cafeteria approach, the employer must face a number of considerations in designing the plan.

The Type and Amount of Benefits To Include

Probably the most fundamental decision that must be made in designing a cafeteria plan involves determining what benefits should be included. An employer who wants the plan to be viewed as meeting the differing needs of employees must receive employee input concerning the types of benefits perceived as most desirable. An open dialogue with employees will undoubtedly lead to suggestions that every possible employee benefit be made available. The enthusiasm of many employees for a cafeteria plan will then be dampened when the employer rejects some—and possibly many—of these suggestions for cost, administrative, or psychological reasons. Consequently, it is important that certain ground rules be established regarding the benefits that are acceptable to the employer.

The employer must decide whether the plan should be limited to the types of benefits provided through traditional group insurance arrangements or be expanded to include other benefits. At a minimum, it is important to ensure that an overall employee benefit program provide employees with protection against all major areas of personal risk. This suggests a benefit program with at least some provision for life insurance, disability income protection, medical expense protection, and retirement benefits, but it is not necessary that all these benefits be included in a cafeteria plan. For example, most employers have a retirement plan that is separate from their cafeteria plan because of Section 125 requirements. Other employers make a 401(k) plan one of the available cafeteria options.

In some respects, a cafeteria plan may be an ideal vehicle for providing less traditional types of benefits. Two examples are extra vacation time and child care. Some plans allow an employee to use flexible credits to purchase additional days of vacation. When available, this option has proven a popular benefit, particularly among single employees. A problem may arise, however, if the work of vacationing employees must be assumed by nonvacationing employees, in addition to their own regularly assigned work. Those not electing extra vacation time may resent doing the work of someone else who is away longer than the normal vacation period.

In recent years, employers have been under increasing pressure to provide care for employees' children, which represents an additional cost if added to a traditional benefit program. Employees who include child-care benefits in a cafeteria plan can pay for the cost of such benefits, possibly with dollars from an FSA. However, lower-paid employees may be better off financially by paying for child care with out-of-pocket dollars and electing the income tax credit available for dependent-care expenses.

One question that sometimes arises is whether dependent life insurance should be included in a cafeteria plan. As mentioned previously, amounts of $2,000 or less do not fit the definition of a qualified benefit and cannot be included. If the amount of coverage available exceeds $2,000, the benefit can be provided as long as it is treated as a cash benefit. An employee who elects coverage with employer-provided dollars will have taxable income as determined by Uniform Premium Table I. Because this amount will exceed the actual cost of the coverage in some cases, dependent life insurance is often made available outside a cafeteria plan. When it is included in a cafeteria plan, there is frequently a requirement that it be purchased with after-tax salary reductions.

Cost is an important consideration in a cafeteria plan. The greater the number of benefits, particularly optional benefits, the greater the administrative costs. A wide array of options may also be confusing to many employees and require extra personnel to counsel employees or to answer their questions.

Level of Employer Contributions

An employer has considerable latitude in determining the amount of dollars that will be available to employees to purchase benefits under a cafeteria plan. These dollars may be a function of one or more of the following factors: salary, age, family status, and length of service.

A major difficulty arises in situations in which the installation of a cafeteria plan is not accompanied by an overall increase in the amount of the employer's contributions to the employee benefit plan. It is generally felt that each employee should be provided with enough dollars so that he or she can purchase optional benefits that, together with basic benefits, are at least equivalent to the benefits provided by the old plan.

Including a Premium-Conversion or FSA Option

A premium-conversion or FSA option under a cafeteria plan enables employees to lower their taxes and, therefore, increase their spendable income. Ignoring any administrative costs, there is probably no reason not to offer this option to employees for benefits such as dependent care or for health insurance premiums. However, salary reductions for unreimbursed medical expenses pose a dilemma. While such deductions save taxes for an employee, they may also result in his or her obtaining nearly 100 percent reimbursement for medical expenses, which may negate many of the cost-containment features in the employer's medical expense plan.

Change of Benefits

Because employees' needs change over time, a provision regarding their ability to change their benefit options must be incorporated in a cafeteria plan. As a rule, changes are allowed prior to the beginning of the plan year. Additional changes may be allowed as long as they are permissible under Section 125 regulations.

Two situations often affect the frequency with which benefits may be changed. First, charges to employees for optional benefits must be adjusted periodically to reflect experience under the plan. If charges for benefits rise between dates on which employees may change benefit selections, the employer must either absorb these charges or pass them on to the employees, probably through increased payroll deductions. Consequently, most cafeteria plans allow benefit changes on annual dates that are the same as the dates when charges for benefits are recalculated as well as the dates on which any insurance contracts providing benefits under the plan are renewed.

The second situation arises when the amount of the employer's contribution is based on compensation. If an employee receives a pay increase between selection periods, should he or she be granted more dollars to purchase additional benefits at that time? Under most cafeteria plans, the dollars available to all employees are calculated only once a year, usually before the date by which any annual benefit changes must be made. Any changes in the employee's status during the year will have no effect on the employer's contribution until the date on which a recalculation is made in the following year.

THE RATIONALE FOR CAFETERIA PLANS

The growth in employee benefits has caused two problems. First, some employers feel that many employees do not recognize and appreciate the magnitude of their employee benefits; indeed, as benefits increase, employee appreciation often seems to decrease. Advocates of cafeteria plans argue that by giving employees a stated dollar amount with which they must select their own benefits (from a list of options), employees become more aware of the actual cost of these benefits and are more likely to appreciate the benefits they choose.

A second problem is that the inflexible benefit structure of conventional employee benefit plans does not adequately meet the various benefit needs of all employees, often leading to employee dissatisfaction. For example, single employees often resent the medical coverage that married employees receive for their families because the single employees receive no benefit of corresponding value. Similarly, employees who have no dependents often see little value in life insurance and would prefer other benefits. Those who favor the concept of cafeteria plans feel that such dissatisfaction can be minimized if employees have the option to select their own benefits. Advocates of cafeteria plans argue that this increased employee satisfaction will result in a better employee-retention record and in greater ability to attract new employees.

Some employers see the cafeteria approach to benefit planning as an opportunity to control the escalating benefit costs associated with inflation and with the new requirements of recently enacted federal and state legislation. Because a cafeteria plan is essentially a defined-contribution plan rather than a defined-benefit plan, it provides a number of opportunities for controlling increases in costs. For example, it may encourage employees to choose medical expense options that have larger deductibles or a greater degree of managed care so that they can more efficiently use the fixed number of dollars allotted to them under the plan. A cafeteria plan may also enable the employer to pass on to the employees any increased benefit costs that result from having to comply with legislation that mandates additional benefits. In addition, because increases in employer contributions are not directly related to increases in benefit costs, the employer can grant percentage increases in the amounts available for benefits that are less than the actual overall increase in employee benefit costs.

It should be noted that early cafeteria plans were designed primarily to meet the varying needs of employees. In contrast, newer plans are much more likely to be instituted as a cost-saving technique.

THE NATURE OF CAFETERIA PLANS

In its purest sense, a cafeteria plan can be defined as any employee benefit plan that allows an employee to have some choice in designing his or her own benefit package by selecting different types or levels of benefits that are funded with employer dollars. At this extreme, a benefit plan that allows an employee to select an HMO as an option to an insured medical expense plan can be classified as a cafeteria plan. However, the more common use of the term cafeteria plan denotes something much broader—a plan in which choices can be made among several different types of benefits and, possibly, cash.

Prior to the addition of Section 125 to the Internal Revenue Code in 1978, the use of cafeteria plans had potentially adverse tax consequences for an employee. If an employee had a choice among benefits that were normally nontaxable (such as medical expense insurance or disability income insurance) and benefits that were normally taxable (such as life insurance in excess of $50,000 or cash), then the doctrine of constructive receipt resulted in an employee's being taxed as if he or she had elected the maximum dollar amount of taxable benefits that could have been obtained under the plan. For example, if an employee could have elected cash in lieu of being covered under the employer's medical expense plan but chose to remain in the medical expense plan, that employee was considered to have taxable income merely because cash could have been elected. Obviously, this tax environment was not conducive to the use of cafeteria plans unless the only benefits offered were normally of a nontaxable nature.

Permissible Benefits

Section 125 of the Code defines a cafeteria plan as a written plan under which all participants are employees and under which all participants may choose between two or more benefits consisting of (1) qualified benefits and (2) cash. Qualified benefits essentially include any welfare benefits excluded from taxation under the Internal Revenue Code except scholarships and fellowships, transportation benefits, educational assistance, no-additional-cost services, employee discounts, and de minimis fringe benefits. The latter include dependent life insurance coverage in amounts of $2,000 or less. The Health Insurance Portability and Accountability Act (HIPPA) expanded this list of exceptions to include any product that is advertised, marketed, or offered as long-term care insurance. Thus medical expense benefits (other than long-term care insurance), disability benefits, accidental death and dismemberment benefits, vacations, and dependent-care assistance (such as day care centers) can be included in a cafeteria plan. The Code also allows group term life insurance to be included, even in amounts exceeding $50,000. In general, a cafeteria plan cannot include benefits that defer compensation except for a qualified Section 401(k) or similar plan.

The prohibition of benefits that defer compensation has an important impact on vacation benefits. If an employee elects vacation benefits for the plan year of a cafeteria plan, the vacation days cannot be carried over into the following plan year because this would be a deferral of compensation. (Note: Regular vacation days are considered to have been taken before the additional days elected under the cafeteria plan.) However, an employee can elect to exchange these days for cash as long as the election is made and the cash is actually received prior to the end of the plan year. If this is not done, the days are forfeited and their value is lost.

The term cash is actually broader than it would otherwise appear. In addition to the actual receipt of dollars, a benefit is treated as cash as long as (1) it is not a benefit specifically prohibited by Section 125 as cash and (2) it is provided on a taxable basis. This latter provision means that either (1) the cost of the benefit is paid by the employee with after-tax dollars on a payroll-deduction basis or (2) employer dollars are used to obtain the benefit, but the employer reports the cost of the benefit as taxable income for the employee. This rule would allow the inclusion of group automobile insurance or long-term care insurance in a cafeteria plan but not on a tax-favored basis. It also allows long-term disability coverage to be provided on an after-tax basis, so that disability income benefits can be received tax free.

The list of benefits that Section 125 specifically prohibits from being treated as cash includes any benefits provided under Section 117 (scholarships and tuition expenses) and Section 132 (various fringe benefits such as discounts and transportation benefits) of the Internal Revenue Code.

As long as a benefit plan offering choice meets the definition of a cafeteria plan, the issue of constructive receipt does not apply. Employees will have taxable income only to the extent that normally taxable benefits—group term life insurance in excess of $50,000 and cash—are elected. An employer can have a benefit plan that offers choice but does not meet the statutory definition of a cafeteria plan. In such a case the issue of constructive receipt will come into play if the plan contains any benefits that normally result in taxable income.

Choice of Medical Expense Plans

Employers often allow employees a choice of medical expense plans for themselves or their employees. However, there is often confusion over whether this choice constitutes a cafeteria plan. If it does, the employer will need to comply with the rules of Section 125 and ERISA or be subject to the statutory penalties for noncompliance.

Assume an employer has a noncontributory medical expense plan that allows employees to elect among two or more managed care plans. If this is the only choice offered to employees, it is not a cafeteria plan because there is no cash option. It is only a choice among qualified benefits.

Now assume that an employer gives employees the option of electing either a noncontributory managed care plan or an indemnity plan for which the employee must make a monetary contribution on an after-tax basis. Again, by itself this is not a cafeteria plan because there is no option of electing cash. However, if employees are allowed to pay their share of the premiums for the indemnity plan on a before-tax basis through a premium-conversion plan, a cafeteria plan has been created under Section 125. Because salary reductions technically become employer dollars, the employees who elect salary reductions are considered to be choosing between cash and a qualified benefit.

Some employers allow an employee to elect out of medical expense coverage and receive cash. For example, some employees may feel that they do not need coverage under the employer's plan because they are adequately covered under their spouse's plans. If the cost to provide coverage to employees is $2,000 per year, the employer might feel financially justified in offering these employees $1,000 to waive coverage. Since these employees have a choice between the medical expense coverage and cash, a cafeteria plan has been created.

Benefit Election

Section 125 requires that benefit elections under a cafeteria plan be made prior to the beginning of a plan year. These elections cannot be changed during the plan year except under certain specified circumstances if the plan allows such changes. While there is no requirement that these changes be included in a plan, some or all of them are included in most plans.

The Internal Revenue Service (IRS) regulations regarding election changes had remained unchanged through most of the 1990s. In 1997, however, regulations with proposed changes were issued, and employers were allowed to use either the old or the new regulations. In early 2000, the proposed regulations were made final with some modifications; they must be used for plan years beginning on or after January 1, 2001. At the same time, the IRS issued another set of proposed regulations to address issues not covered by the new regulations. Employers also are allowed to use these regulations for plan years beginning on or after January 1, 2001.

The regulations allow new cafeteria plan elections for specified changes in status. In addition, the regulations specify that any new cafeteria plan elections are allowed only if an employee, spouse, or dependent gains or loses eligibility for coverage, and the cafeteria plan election change corresponds with that gain or loss in coverage. The acceptable changes in status include the following:

• Legal marital status (including marriage, death of a spouse, divorce, legal separation, or annulment)

• Number of dependents (resulting from birth, adoption, commencement or termination of an adoption proceeding, or death)

• Employment status (the termination or commencement of employment by the employee, spouse, or dependent)

• Work schedule (a reduction or increase in hours of employment by the employee, spouse, or dependent, including a switch between part-time and full-time employment, a strike or a lockout, and commencement of or return from an unpaid leave of absence)

• Dependent status under a health plan for unmarried dependents

• Residence or worksite of the employee, spouse, or dependent

Regulations address several specific issues. For example, increases in group term insurance coverage and disability income coverages are allowed in the case of marriage, birth, adoption, or placement for adoption. Decreases in coverage are allowed for divorce, legal separation, annulment, or death of a spouse or dependent. The regulations also allow employees to make election changes if, during the plan year, (1) a new benefit package is offered or a benefit package is eliminated or (2) a change is made in the coverage of an employee's spouse or dependent. In addition, an employee can make a change as a result of an open-enrollment change by a spouse or dependent whose employer's plan has a different period of coverage. Finally, an employee can make a change as a result of a spouse's or dependent's change under his or her own cafeteria plan, as long as that change conforms to the regulations.

Even if none of the above rules are met, election changes are permitted in cafeteria plans as a result of changes in coverage or premiums because of HIPAA, COBRA, eligibility for Medicare, or a legal judgment, decree, or order resulting from divorce, legal separation, annulment, or change in legal custody.

Payroll Deductions and Salary Reductions

Under some cafeteria plans, employees are allowed to allocate only a predetermined employer contribution to benefits. Other cafeteria plans are designed so that employees can obtain additional benefits with optional payroll deductions or salary reductions.

Many cafeteria plans that provide a wide array of benefits allow an employee to elect an after-tax payroll deduction to obtain additional benefits. For example, under a cafeteria plan an employee might be given $200 per month with which to select varying types and levels of benefits. If the benefits the employee chooses cost $240, the employee has two options—either to decrease the benefits selected or to authorize a $40 payroll deduction. Even though the payroll deduction is on an after-tax basis, the employee gains to the extent that the additional benefits can be selected through a group arrangement at a lower cost than in the individual marketplace.

Section 125 also allows employees to purchase certain benefits on a before-tax basis through the use of a premium-conversion plan or a flexible spending account (FSA). Premium-conversion plans or FSAs, both of which are technically cafeteria plans, can be used by themselves or incorporated into a more comprehensive cafeteria plan. They are most commonly used alone by small employers who are unwilling to establish a broader plan, primarily for cost reasons. The cafeteria plans of most large employers contain one or both of these arrangements as an integral part of the plan.

Before-tax salary reductions reduce taxable income for federal income tax purposes. In most (but not all) states, they also reduce the income subject to state tax.

Premium-Conversion Plans

A premium-conversion plan (also called a premium-only plan, or POP) allows an employee to elect a before-tax salary reduction to pay his or her premium contribution to any employer-sponsored health or other welfare benefit plan. For example, an employer might provide medical expense coverage to employees at no cost but make a monthly charge for dependent coverage. Under a premium-conversion plan, the employee can pay for the dependent coverage with a before-tax salary reduction.

As a rule, premium-conversion plans are established for medical and dental expenses only. If such plans are used for group term life insurance, the cost of coverage in excess of $50,000 must be reported as income, which defeats the purpose of the salary reduction. If these plans are used for disability income coverage, benefits will be taxable as noncontributory employer-provided coverage because the amount of any salary reduction is considered to be the employer's money.

Flexible Spending Accounts (FSAs)

An FSA allows an employee to fund certain benefits on a before-tax basis by electing to take a salary reduction, which can then be used to fund the cost of any qualified benefits included in the plan. However, FSAs are used almost exclusively for medical and dental expenses not covered by the employer's plan and for dependent-care expenses.

The amount of any salary reduction is, in effect, credited to an employee's reimbursement account, and benefits are paid from this account when an employee properly files for such reimbursement. Reimbursements are typically made on a monthly or quarterly basis. The amount of the salary reduction must be determined prior to the beginning of the plan year. Once the amount is set, changes are allowed only under the specified circumstances previously mentioned for benefit elections. A separate election must be made for each benefit, and the funds are accounted for separately. Monies from a salary reduction for one type of expense cannot be used as reimbursement for another type of expense.

If the monies in the FSA are not used during the plan year, they are forfeited. Because forfeited funds are considered plan assets, they can be used only for the payment of benefits and reasonable administrative expenses. Under ERISA rules, forfeitures may be used to do the following:

• Defray the administrative costs of the plan.

• Protect the underwriting integrity of the plan. This includes the use of these funds to reimburse the plan for benefits paid that exceed a terminated employee's contributions. For example, an employee who contributed $100 per month might be eligible to collect a full annual reimbursement of $1,200 in the first month of participation. If the employee terminated employment at that time, the plan would have paid out $1,100 more than it had taken in.

• Reallocate contribution to the following plan year. Such reallocations must be on a per capita basis for all participants and cannot be based on amounts each employee originally contributed.

The ERISA rules specifically prohibit the donating of forfeitures to charity or the reversion of such amounts to the employer for general business expenses.

An election to participate in an FSA program not only reduces a salary for federal income tax purposes but also lowers the wages on which Social Security and Medicare taxes are levied. As a result, those employees who end up below the Social Security wage-base limit after the reduction pay less in Social Security taxes, and their future income benefits under Social Security may be reduced. However, the reduction in future benefits is small in most cases, unless the salary reduction is large. It should be noted that the employer's share of Social Security and Medicare tax payments also decreases. In some cases, the employer's savings may actually be large enough to fully offset the cost of administering the FSA program.

One issue faced by employers over the years has been whether to limit benefit payments to the amount of an account balance or to allow an employee at any time during the year to receive benefits equal to his or her annual salary reduction. For example, say an employee contributes $100 per month to an FSA to provide benefits for the cost of unreimbursed medical expenses. During the first month of the plan, the employee earns only $100 of the $1,200 annual contribution. If the employee incurs $300 of unreimbursed medical expenses during the month, should he or she be allowed to withdraw $100 or the full $300? The objection to allowing a $300 withdrawal is that the employer will lose $200 if the employee terminates employment before making any further contribution. IRS regulations do not give the employer any choice with respect to health benefits (that is, medical and dental expenses); FSAs must allow an amount equal to the full annual contribution to be taken as benefits any time during the year. Therefore, the employee is entitled to a benefit of $300 after the first month. However, IRS regulations do allow a choice in reimbursement policies for other types of benefits, such as dependent-care expenses. For these benefits, most plans limit aggregate benefits to the total contributions made up until the time when benefits are received.

Types of Plans | GROUP LEGAL EXPENSE INSURANCE

The types of group legal expense plans vary significantly in the ways they provide legal services. When an employer or negotiated trusteeship establishes a group legal expense plan, benefits can be self-funded or purchased from another organization. These other organizations include state bar associations, groups of attorneys, or other organizations (either profit or nonprofit) formed for this purpose. However, most group legal expense coverage is purchased from a relatively small number of organizations, several of which have recently affiliated with insurance companies.

Existing plans fall into one of three types of arrangements:

1. Referral and discount plans

2. Access plans

3. Comprehensive plans

Referral and Discount Plans

The most basic form of legal expense plan is one that involves referrals and discounts. Plan members are referred to an attorney who provides services based on a fee schedule or at a discount from his or her usual fees, but the attorney's charges are paid by the plan member. In some cases, plan members may be eligible to be referred to attorneys who provide free services, such as a clinic for low-income persons or an attorney hotline of a local bar association.

Access Plans

This form of legal expense plan, sometimes also called a telephone access plan, provides plan members with unlimited legal consultation over the telephone for most legal matters. The plan may also provide simple legal services, such as the preparation of wills or powers of attorney or the review of legal documents.

Plan members are referred to an attorney for more complex legal matters. The attorney will often provide an initial free consultation (usually either one-half or one hour), after which the attorney will bill at some discount (often 25 percent) from normal fees. A plan member is responsible for paying this discounted fee.

Access plans can often be provided at a cost of $5 to $10 per month per member.

Comprehensive Plans

Most legal expense plans can be categorized as comprehensive plans, and premiums usually fall in the range of $10 to $20 per month per member, depending on the level of services provided.

In addition to telephone consultation, comprehensive plans cover in-office and trial work of attorneys. The term comprehensive may be a slight misnomer because most plans are not designed to cover 100 percent of a member's potential legal services; 80 to 90 percent is probably a better figure.

Comprehensive plans usually contain a list of covered services. While there are significant variations among plans, most cover at least the following:

• Unlimited legal advice by telephone

• Document review and preparation

• Name changes

• Adoptions

• Purchase or sale of primary residences

• Eviction defense

• Civil actions

• Driver's license suspension

• Juvenile court proceedings

• Consumer protection

• Bankruptcy

• IRS audits

• Debt collection

• Child custody and support

• Divorce, but possibly only for the covered employee and not dependents

If a particular legal service that is required is not on the list of covered services, there may be some limited coverage as long as the service is not otherwise excluded. This limited service, for example, may be in the form of telephone consultation or a limited amount of work by the attorney, such as two to four hours per family per year.

Legal expense plans have exclusions, and common exclusions include the following:

• Business activities or transactions

• Preparation of tax returns

• Class-action suits

• Actions involving the legal expense plan

• Actions involving the employer

• Actions involving the union that bargained for the coverage

• Cases that have contingent fees

Comprehensive plans take three approaches to the method by which a plan member may select an attorney. Many plans use a closed-panel approach, under which a panel of attorneys has agreed to provide covered services at a predetermined fee or hourly rate for which they bill the plan. The plan member selects the attorney, and benefits are generally available at little or no additional cost. However, plans may limit some benefits to a scheduled maximum (such as $500) and usage limitation (such as four hours). A few plans also have deductibles and copayments.

Other plans are open-panel. A plan member can choose any licensed attorney; however, plan benefits are usually subject to scheduled dollar maximums.

Many plans are modified-panel plans. Under such plans, a plan member may choose either a panel attorney, as in a closed-panel plan, or select his or her own attorney. The election of a panel attorney often results in benefits being paid in full, while the election of a nonpanel attorney results in the use of benefit maximums.

COMPARISON OF TYPICAL MEDICAL EXPENSE PLANS

There are various types of medical expense plans and how they differ. While variations within each type of plan exist, some generalizations can be made. These are summarized in Table below. The degree of managed care increases as one moves from left to right in the table. However, the cost of the plans, on the average, decreases as the degree of managed care increases. In addition, a higher degree of managed care is generally associated with lower annual premium increases by a plan.

Group Medical Expense Benefits, Managed Care Plans - MULTIPLE-OPTION PLANS

Until recently, an employer who wanted to make an HMO or POS option available to employees had to enter into a separate contractual arrangement with an HMO. Unless a PPO was sponsored by the insurance company or Blue Cross-Blue Shield plan of an employer, a similar contractual arrangement was also required. Several insurance companies and Blue Cross-Blue Shield plans are now providing all these options under a single medical expense contract. For example, one insurer markets a so-called quadruple-option plan that gives employees the choice of a traditional major medical contract, a PPO, an HMO, or a POS plan. In most cases, the HMOs and PPOs used in such arrangements have been formed or purchased by the insurance company or Blue Cross-Blue Shield plan, but occasionally a contractual relationship has been established with an existing HMO or PPO. HMOs, in addition to offering POS options, also frequently offer PPO products to employers as part of a multiple-option plan.

These plans offer certain advantages to the employer. First, administration is easier because all elements of the plan are purchased from a single provider. Second, costs may be lower because the entire plan, including the HMO, may be subject to experience rating. Because federally qualified HMOs cannot fully use experience rating (particularly on a retrospective basis), only nonfederally qualified HMOs are often used in multiple-option plans.

POINT-OF-SERVICE PLANS

A newer and fast-growing type of managed care arrangement is the POS plan. A POS plan is a hybrid arrangement that combines aspects of a traditional HMO and a PPO. With a POS plan, participants in the plan elect, at the time medical treatment is needed, whether to receive treatment within the plan's tightly managed network, usually an HMO, or outside the network. Expenses received outside the network are reimbursed in the same manner as described earlier for nonnetwork services under PPO plans.

There are two basic types of POS plans: the open-ended HMO and the gatekeeper PPO. An open-ended HMO is by far the most common form and is the HMO industry's response to the demand for more consumer flexibility in the choice of providers, even though it increases costs somewhat. It essentially consists of traditional HMO coverage with an endorsement for nonnetwork coverage. It can take the basic form of any of the HMOs previously described. However, at any time a subscriber can elect to go outside the HMO network of medical care providers.

It can be argued that any PPO is actually a POS plan. However, the normal usage of the term POS implies a higher degree of managed care than is found in most PPOs. A gatekeeper PPO requires that the PPO participant elect a primary care physician in the manner of an HMO participant. This physician acts as a gatekeeper to control utilization and refer members to specialists within the PPO network. However, any time that care is needed a covered person can elect to go outside the network. This type of PPO has generally been formed by a traditional PPO or insurance company that does not own an HMO.

Under some POS plans, a covered person can go outside the plan's network without informing the plan of this fact. In other POS plans, the person must notify the gatekeeper that such treatment will be sought. Even though the gatekeeper has no power to prevent the nonnetwork treatment, the gatekeeper may be able to convince the person that proper treatment is available within the network. Furthermore, the gatekeeper can better manage future medical care by being aware of all medical treatment that a person is receiving.